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BankruptcyData Begins Special Coverage of Sears Rescue Efforts

On September 23, 2018, ESL Partners, L.P. (the eponymously named investment vehicle of Edward S Lampert, “Mr Lampert”) delivered a proposal (the “ESL Proposal”) to the Board of Sears Holdings, Inc. outlining a plan to rescue the Sears retail empire (including inter alia, 547 Sears stores and 432 KMart stores) from bankruptcy and possible liquidation (the “Rescue Plan”). 
The Rescue Plan (filed with the SEC) is the latest in many efforts by Mr Lampert to squeeze liquidity out of Sear’s vast bricks-and-mortar retail empire, and to find extra breathing room for a complicated capital structure caught in a chokehold. 
The Rescue Plan, however, is not just another effort to find cash in one corner or another of Sear’s shrinking empire or balance sheet. It is an attempt to find, aggregate and monetize whatever is left; a last marshalling of effort and resource that will either see Sears rescued or foundered.
This BankruptcyData special report examines the Rescue Plan and its elements.  It is a “living document” that will be regularly updated to reflect the evolving nature of this existential stage in Sears’ corporate life.
One of the few certainties about Sears’ near-term future is that the Rescue Plan will change significantly in coming weeks, if it gets past the first hurdle at all. There are too many assumptions, transparently self-serving proposals and internal tensions for it to advance meaningfully without major changes. Even if the Rescue Plan is not adopted, and the company does slide into bankruptcy, the Rescue Plan has enormous significance. Any proposals eventually put forth by ESL in the bankruptcy context are likely to very much resemble what ESL is proposing in the Rescue Plan. In (or out of) bankruptcy, Mr Lampert and ESL hold sufficient leverage as a shareholder and creditor to steer Sears’ next chapter. The Rescue Plan is, if nothing more, a harbinger of what to expect a Chapter 11 Plan.
It should be noted at the outset, that the Rescue Plan primarily addresses Sears’ ability to restructure its balance sheet and largely inores whether Sears has a viable operational path going forward. Although the Sears Board will be examining the feasibility of the Rescue Plan, they will be equally focussed on ESL’s operational arguments.  What is the point of fixing balance sheet and liquidity issues in the absence of a viable underlying business.…and if there is no operational viability going forward, why would creditors, secured or otherwise allow another penny of Sears’ remaining value to be squandered outside of bankruptcy? 
Crucial to any understanding of how the Sears saga will unfold is also understanding Mr Lampert himself. Sears may have once been “Where America Shops” but it is now effectively the store that is being shopped by one American. What does Mr Lampert want and how does he intend to do it? Is Eddie Lampert trying to rescue his return on investment in the short-term or is he trying to rescue Sears with a view to a longer-term return? 
Looking at Lampert’s Sears equity and debt holdings will allow for a better understanding of how he may maximize the return on his investments. Even with that information, an understanding of Mr Lampert’s goals is incomplete. A once celebrated visionary with epic investment victories, he is now recharacterized as a man blinkered to the ultimate fate of Sears. It is no surprise that Mr Lampert has spawned a cottage industry of experts trying to unpick the mysteries of the iconoclastic billionaire.
“Transforming Sears Holdings – A Proposal from ESL Investments, Inc. Creating Value for All Stakeholders” 
The ESL Proposal is comprised of three principal groupings of corporate actions: 
(i)            liability management transactions[1],
(ii)           real estate transactions and 
(iii)          asset sales 
Collectively, the three are intended to extend near-term debt maturities, reduce long-term debt, eliminate associated cash interest obligations and obtain additional liquidity.
In the first of our ongoing series on the looming final chapter (will it be 11?) of the die-hard retailer’s efforts to rescue itself, we examine the second prong (“Real Estate Transaction”) of the Rescue Plan. It is to date the least understood and examined. It is also paradoxically where perhaps there is the most value to play for.

Real Estate Transactions
         Seritage: A Prelude

The real estate element of the ESL Proposal will ring bells for many, as ESL has significant experience with the purchase of Sears Holdings’ properties and subsequent efforts to monetize those purchases, including through mixed-used conversion and sale/leaseback transactions to Sears Holdings. 
In June of 2015, Sears Holdings effected a rights offering to its stockholders to purchase common shares of Seritage Growth Properties (“Seritage”), a NYSE-listed real estate investment trust (REIT) formed on June 3, 2015 and created to fund, in part, the $2.7 billion acquisition of 234 of Sears Holdings’ owned properties. As of December 31, 2017, Seritage leased space at 148 of those properties to Sears Holdings. In SEC filings, Seritage states that its business strategies include:
(i)            Converting single-tenant buildings into multi-tenant properties at meaningfully higher rents, 
(ii)           Maximizing value of vast land holdings through retail and mixed-use densification and 
(iii)          Leveraging existing and future joint venture relationships with leading real estate and financial partners. 
Seritage’s assets are held by, and its operations are primarily conducted through, Seritage Growth Properties, L.P., a Delaware limited partnership. This partnership is 36.2% owned by ESL. Seritage’s Chairman is none other than Edward S Lampert. 
Seritage and Sears Holdings may share important common stakeholders, but they have not shared similar economic fortunes. At the end of July 2018, as Sears slid inexorably into its current morass and towards a $1 share price, Seritage was being bestowed with a rare honor, a $2 billion loan facility (and a 13% one-day share price jump) funded by none other than Warren Buffet’s Berkshire Hathaway.
Now fast forward three years to the Rescue Plan. According to the ESL Proposal, the proposed real estate transactions stand to eliminate approximately $1.5 billion of real estate debt, provide significant liquidity to Sears Holdings via cash interest savings and transfer the real estate related risk/opportunity to a consortium of lenders (“the Consortium”) that ESL would be willing to lead  (NB: According to the ESL Proposal, ESL holds $1,167 million of the $1,474 million of secured real estate debt, or 79.2 %, so to a large extent ESL is the Consortium). 
This real estate proposal is what will likely attract the most scrutiny from investors and potential litigants (not to mention Sears Holdings’ Independent Directors) due to (i) the role that ESL proposes to play on both sides of the coin and on an ongoing basis and (ii) the differing opinions on the actual market value of Sears Holdings property. 
Cynical minds might also posit that ESL is trying to purchase assets in exactly the same manner as it might in a Section 363 sale process under Chapter 11, except that it gets to play “stalking horse” in a guaranteed one-horse race, having named its purchase price (an amount equivalent to real estate-related debt that ESL…or rather the Consortium…holds) and effectively credit bid that debt (eg buy the Sears Holding real estate portfolio with outstanding debt).  One does not, however, have to be cynical to realize that many of the elements of the proposed real estate transaction parallel and dovetail with ESL’s Seritage experience.
Key real estate elements of the ESL Proposal include:
  • Sears Holdings would continue marketing efforts in respect of its “encumbered” (ie, used as collateral to secure borrowings under lending agreements) real estate portfolio for 12 months. During that 12 months, cash interest in respect of real estate debt held by members of the Consortium would convert to PIK interest and be added to the principal.  The ESL Proposal calculates the cash interest saving to be $139 million during the 12 months (this based on an assumed 12.1% interest rate on the $1,167 million of real estate debt currently held by ESL). Is this a cash interest savings (perhaps not in a bankruptcy proceeding)…and is 12.1% a reasonable interest rate on which to base those savings? 
  • At the end of the 12-month period, all of the sales proceeds would be used to repay third party “first-out” (ie priority) real estate lenders and then ESL. The ESL Proposal does not make clear what percentage of the $307 million NOT held by ESL would qualify as senior to ESL’s own secured holding (which is itself first lien debt).
  • Also at the end of the 12-month period, any encumbered real estate that has not yet been sold … would be sold to the Consortium in exchange for cancellation of the then-existing real estate debt (including the 12.1 % interest accrued over the 12 months). In essence, ESL is proposing that (after getting full recovery in cash in respect of its debt secured by sold properties) all of Sears Holdings’ encumbered real estate be sold to the Consortium for the face value of the debt it still holds (ie subtracting the amount of debt repaid from any proceeds of property sales);
   This element of the transaction, if agreed, will be where fortunes are won or lost and where bitter debates as to valuation will undoubtedly occur. The ESL Proposal notes that the “Appraised Value” of the relevant property portfolio is $1,972 million. It further suggests a “Dark Value” (this value reflecting the diminished value of Sears Holdings properties either vacant or occupied by a questionable tenant like Sears) of $1,260 million. Falling in the middle of the range thus created by ESL, is ESL’s proffered purchase price of $1,472 million (the value of Sears Holdings debt secured by real estate) puffed up by that frothy 12.1% PIK interest that has been rolled up into outstanding principal over 12 months. 
  • Having purchased the remaining Sears Holdings properties, the Consortium would then lease back a pre-agreed number of those properties/stores to Sears Holdings, exactly as Seritage now does in respect of @148 former Sears Holding properties. Whether restructured (under Chapter 11 or otherwise), or sent into liquidation, one question that will bear significantly on ESL’s preferred outcome for Sears is what impact that outcome will have on the income generating potential of Sears’ property portfolio. Does ESL need, or want, Sears as a revenue generating tenant or does it see more profitable returns from re-purposing of those properties? ESL’s management of Seritage, where Sears remains an important tenant, may provide a clue; and certainly one has to be left wondering whether ESL could support in the short-term the massive influx of properties without certain rental income. What is certain, however, is that ESL’s strategy in respect of Sears will cross over into its strategy in respect of Seritage; as both ESL’s Consortium and Seritage will be carefully assessing a future with or without Sears as a tenant. 
  • The ESL Proposal concludes with, at the very least, lip service to the interests of other stakeholders.  It states,“The Company will share (70% to the Consortium and 30% to Sears Holdings) in the profits of real estate sales above a 10% annually compounding preferred return to the Consortium (the ‘Hurdle’).”  This allows ESL to claim that its Proposal “allows the company to maintain economic interest in long term value of real estate without debt burden.” The Proposal’s own “Illustrative Example” suggests, however, that Sears Holdings’ potential upside from this profit share is attenuated if not entirely illusory; perhaps unsurprising given the 10% compounded interest, which raises the Hurdle by $110 million in year one…and grows from there. A second stakeholder friendly feature is that the Consortium would provide an opportunity to “qualified” Sears shareholders to participate in a rights offering, pursuant to a private placement, in a real estate portfolio transaction on a pro rata basis based on their existing Sears equity investment. Given that Lampert and ESL hold a dominant share of that equity and that a private placement would limit involvement to large investors, this commitment (which reminds of Seritage’s 2015 rights offering) may be of limited value. What it does do, however, is provide useful optics to ESL as it pitches to the Sears Holdings’ Board and perhaps eventually to a Bankruptcy Court. Even more than ESL, perhaps, it is the Sears Holdings’ Board that needs to be able to counter inevitable charges that it is not, given Lampert and ESL’s ubiquitous presence, capable of an independent assessment of this, or any other, proposal. The ESL Proposal at least recognizes this uncomfortable position.
[1] Transactions that are used to “manage” the “liabilities” of an issuer where “Liability” references contractual obligations contained in existing securities (eg (i) payment obligations (financial liabilities) or (ii) affirmative or negative covenants (covenant liabilities)) and “Management” references the modification or elimination of such liabilities.

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